How do you pick a good real estate investment?

Posted by Mark Chapman on July 19th, 2010 at 11:45 pm

Dane Hahn

By Dane Hahn

The Realty Column

Ques­tion: I’m think­ing of mak­ing a real estate invest­ment. What is the magic for­mula investors use to deter­mine if a prop­erty would be a good investment?

Answer: This is a good ques­tion and you might not even find the answer at a four-year col­lege offer­ing a real estate diploma — so I’ll try to keep my answer sim­ple. Always remem­ber com­mon sense should rule the day. Invest­ment prop­er­ties take your time and money, so be sure to get your spouse’s approval.

First of all — and you may have heard me say this before — you make money when you buy, not when you sell. The bet­ter the deal you get going in will set the tone for your invest­ment, so find­ing the right prop­erty at the right price makes invest­ing easy. But try­ing to make a good invest­ment out of a bad pur­chase is pure torture.

Before you start, you must have to have a sense of what kind of rent you can expect to get, and what kind of occu­pancy rate is real­is­tic. For exam­ple, if you rent a house or apart­ment to stu­dents in a col­lage town, under­stand that, dur­ing sum­mer, you should expect vacan­cies. If you rent to com­mer­cial inter­ests, like a chain retailer, you will have fewer vacan­cies but a larger invest­ment and more main­te­nance respon­si­bil­i­ties. For eval­u­a­tion pur­poses, I con­sider a house will pro­vide 10 months of rental per year — even if I hope for 12.

First-time investors usu­ally are think­ing about a low-priced invest­ment. They have found a cheap house or duplex and won­der if it would work for them. Many investors think the magic for­mula is col­lect­ing 1 per­cent of the value of the house each month as rent. For exam­ple, if you pay $110,000 for a home, will you be able to charge — and get — $1,100 per month in rent? That’s usu­ally a good start­ing place, depend­ing on your mar­ket. But con­sider that if you buy a home for $100,000 and it costs you $10,000 to make it rentable, then it is a $110,000 house—but that last $10,000 was not part of the mort­gage — it was out of pocket.

You should learn to com­plete an analy­sis that includes your pro­jected income less vacancy rate (adjusted gross income) less all your expenses; (mort­gage, insur­ance, taxes, HOA dues, util­i­ties that you will pay, main­te­nance and repairs and man­age­ment fees). Along with the monthly fig­ures, you should have a sense of where the mar­ket is going and how that will impact the prop­erty in question.

That means your big pay­off is either in a strong monthly income or a strong resale of the prop­erty down­stream. Your invest­ment starts with the acqui­si­tion of the prop­erty and is not com­plete until you have divested it. Just remember:

• Income must exceed expenses. You will want to involve an accoun­tant, since there are var­i­ous fac­tors to con­sider such as depre­ci­a­tion, which can reduce your tax­able income and your income tax bracket but will be recap­tured on sale.

• Return On Invest­ment. The point here is that you’re going to take a chunk of your own money and invest it. Maybe you’d invest it in the stock mar­ket, maybe in CD’s or maybe in real estate. So let’s say you have $60,000 to invest and there’s a house worth $300,000. That’s 20 per­cent down. So you mort­gage the other 80 per­cent and make the pur­chase. Sup­pose you have a pos­i­tive net cash flow from this trans­ac­tion every month of $500. Is that a good use of your money? Well, you’re earn­ing $6,000 a year on a $60,000 invest­ment. That’s 10 per­cent, and in anybody’s mar­ket that’s pretty good.

• Return on equity. When you start out, using the exam­ple above, you’ll have $60,000 in equity in that $300,000 prop­erty. So ini­tially your ROI and ROE is 10 per­cent. And let’s assume that you’re happy with that. But in 10 years or so, the value of the prop­erty may have gone up, increas­ing the equity. And, over the 10 years, you’ve paid down the mort­gage some, also increas­ing the equity. Let’s say the prop­erty is now worth $400,000 and the mort­gage is paid down to $200,000. You now have $200,000 equity in the prop­erty;  if you’re still only get­ting $6,000 a year, then that’s only a 3 per­cent return. Now, real­is­ti­cally, you’ll prob­a­bly have raised the rent some. If you are able to get back to to that ini­tial 10 per­cent ROE, you’d need to be bring­ing in $20,000 a year, or $1,667 a month. As you can see these invest­ments need to be mon­i­tored and rent adjusted if possible.

Because most rentals reach a point where they start to decline in effec­tive return on equity (and this will be some years away), you would then con­sider trad­ing up. Of course, nobody ever thought that the mar­ket would erode the equity in invest­ment or res­i­den­tial prop­er­ties as it has over the past two years—but even so, the con­cept stands.

One bonus that is avail­able today — and hope­fully will still be avail­able when you need it: con­sider a 1031 Exchange. This puts off hav­ing to pay cap­i­tal gains on the sale of appre­ci­ated prop­erty. You can also own the invest­ment prop­erty in your IRA, allow­ing you to trade at will with­out tax con­se­quences. But I am get­ting too tech­ni­cal just now, so when you arrive at the time that you want to trade up, by then you will know all of this from per­sonal expe­ri­ence, and you will have your own real estate invest­ment diploma.

Hope this helps.

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If you have a real estate ques­tion you would like answered, address it to Dane Hahn, please include a phone num­ber so if I have addi­tional ques­tions I can call you. Send your ques­tions to dane.hahn@gmail.com

Dane Hahn is affil­i­ated with Tar­pon Coast Realty which has offices in Engle­wood, Boca Grande and Sara­sota. To reach him by phone call 603−566−5460.

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